Shares digital

Overturn market orthodoxy and avoid companies that blow your cash

Ancient City wisdom has it that company share buybacks are something to be cheered and adored. The truth is very different, and share buybacks are not far removed from throwing hard currency on the fire.

The theory behind share buybacks is deep-rooted within the mindset of most investors, professional and private. It implies that, instead of companies either ending up with vast mountains of cash sitting around the balance sheet idle, or worse still, blowing it on ill-considered acquisitions, they use it to scoop up vast chunks of their own, supposedly, undervalued stock, bolstering earnings and sparking a rise in the share price. It’s a sort of indirect way of handing the surplus cash back to investors, so everyone’s happy right?

Wrong! Not only do the share prices of companies that do follow this strategy, underperform over time, it has been discovered that some company directors use buybacks as a convenient excuse to boost their own inflated pay packets.

The United Kingdom Shareholders’ Association (UKSA) believes that market share buybacks are often contrary to the interests of shareholders – especially private shareholders, which it represents.

UKSA argues that many buybacks are not prudent for balance sheet reasons and divert cash that should be paid out in dividends to shareholders.

The association recommends:

1 companies should circulate to shareholders the reasons favouring the proposal, as well as listing any disadvantages;

2 directors should make sure that a buyback, if chosen over a special dividend or return of capital, is in the best interests of all shareholders and not to protect management against an unwelcome takeover or improve management benefits under option or other remuneration schemes;

3 the company should give all shareholders an equal opportunity to participate in the buyback rather than just institutions;

4 directors should bear in mind the risk of purchasing shares shortly before a significant fall in the share price. When this has been done by a market purchase rather than a proportional offer the sellers will have benefited at the expense of continuing shareholders ‘who will understandably feel aggrieved’;

5 the annual report should state the number of shares purchased, average price paid and percentage of shares cancelled;

6 directors should state how successful the buyback programme has been in achieving the objectives stated in recommendation 1.

UKSA is particularly upset by ‘unreasonable’ buyback programmes undertaken by Surfcontrol, Compass and Rank.

Software company Surfcontrol (taken over late last year) built up £33 million cash but never paid a dividend during its eight years as a plc. It did not invest in new ventures or buy other companies.

Surfcontrol bought back its own shares instead of paying dividends. But the share price performed poorly until the takeover, making the buybacks a poor way to use shareholders’ funds.

No doubt UKSA is equally concerned about Spirent Communications, which sells kit to test telecom networks and products.

Spirent has not paid a penny dividend for seven years but spent £75 million last year buying back over 100 million shares. Unfortunately the shares finished the year little above the 55p level at which they started though they did peak at 79p. Today they are around 70p.

Why buy back?

One big reason why companies stage buybacks instead of paying dividends is that the buyback does not incur any liability to the recipient while the dividend will incur a tax charge for both an institution and individual taxpayer.

The tax rockets to 32.5% for a higher-rate taxpayer for the portion of the dividend income that exceeds the tax threshold.

The only way around it is to have ISAs, Peps and Sipps, where no tax is payable either on dividends or capital gains tax.

The prime factor cited by most companies is that share buybacks reduce the number of shares outstanding. The shares are bought from investors and cancelled. This increases the earnings on each remaining share in issue and theoretically leads to a higher analyst rating and share price. The lower the PE the more effect this will have.

The buyback position was strengthened in April 1999 following the abolition of advance corporation tax (ACT). Before this date, open market repurchases qualified as distributions for tax purposes and so gave rise to a higher ACT charge.

Large institutional shareholders have also put pressure on boards to return cash to them direct. The company broker approaches major shareholders to purchase their shares rather than bothering to make an offer to small private shareholders.

Buybacks also allow management more wriggle room. When there is lots of cash, such as with oil companies enjoying bumper profits due to the record oil price, they can use it to buy back shares rather than commit to regular dividend payments, which they might not be able to afford in the lean years.

A company can pause or halt its repurchase programme with far less adverse publicity than cutting its dividend.

Lastly, a buyback is a good way of helping firms adjust their gearing, says Dr Steven Young, professor of accounting at Lancaster University Management School. If the company is under-geared it can borrow money and buy back its shares to make the balance sheet more efficient. This depends on whether debt is cheaper than equity, which has been the case until recently.

Cosy relationship

It seems that most fund managers can’t explain the tax advantages of buybacks versus dividends or whether there is one. They are also ignorant of research on the subject of which is best – dividends or buybacks.

When a company’s broker rings up and asks them if they want to sell their shares, they are likely to sell – especially if they have already told the company they favour buybacks. Therefore the whole process can be viewed as cosy collusion between City institutions and directors.

The directors benefit by increasing their remuneration if it is linked to EPS growth. They also benefit by responding to institutional pressure for a return of cash. The institutions benefit because they know the company’s broker will buy their shares. The broker benefits by receiving commission.

Big shareholders who press for share buybacks are already feeling negative about that company’s prospects. BP, for instance, plausibly argued it could not earn more from its surplus cash than investors so it returned it to them – mostly by buying back shares.

This might have maintained the share price at a higher level than it would otherwise have achieved if institutions would have sold anyway. On the other hand, institutions need to maintain strict weightings of big company stock so they don’t underperform.

Buybacks allow them to reduce financial exposure to low-growth companies while simultaneously maintaining the same percentage holding.

The buyback frenzy peaked in 2006, with £40 billion returned to shareholders compared with £63 billion via dividends. Buybacks were almost unheard of in the UK until the mid-1990s, when they were imported from America.

Spending fell to £32 billion of repurchases last year and Morgan Stanley expects the total to fall faster this year to around £20 billion.

So the tide might be turning against buybacks even as the evidence mounts conclusively against them as an efficient enhancer of value to shareholders. But with one major caveat; they work much better in a bear market, which we might be in today.

The Morgan Stanley research shows that buybacks ‘only generally support share prices in weak equity markets.’ In the period 2000-04 the top 25% of buybacks did better than those companies not buying back their shares but still underperformed the top quartile of strongest dividend growers.

Go for dividends

It was Morgan Stanley’s May 2007 paper entitled Dividends are more effective than buybacks that really put the cat among the pigeons. Previous research had not delivered such a clear-cut message. Put simply, the Morgan Stanley note concluded that buybacks only support share prices in weak equity markets and stocks with a high buyback yield badly underperformed in the three years 2003-06.

A company that undertook a buyback in 1997 saw its shares rise an average of 8.3% a year over the next ten years compared with a 10.3% return for the market as a whole and 12.7% for firms that boosted their dividends that year.

The message is clear for investors and the City. Buy shares in companies that raise their dividends the fastest as these outperformed the market by 20% in the past decade and in every year except 1999 including the bear market of 2000-02.

Morgan Stanley research shows the top quartile of buyback yields produced a respectable return of 12% from 1997-2006 but outperformance was limited to the years 2000-04.

The good news, says Morgan Stanley, is: ‘In this current environment of volatile markets, where we see little upside on a medium-term basis, it is likely that those stocks that actually continue or step up their buyback programme may well be rewarded as they were in the 2000-2002 bear market.’

Graham Secker, Morgan Stanley co-author of Easy come easy go ... the volatility of buybacks, expects buybacks to remain popular despite the evidence he has produced. ‘Buybacks are seen as good as they boost EPS.’

The other positive for buybacks is that share prices can outperform the market in the short term, especially on the day a buyback is announced, when prices rise an average of 2%, says Young.

Too often, however, share repurchases are used to show management is doing something positive to counteract a falling share price, which might be happening because of management mistakes.

A good example is Trinity Mirror’s £250 million buyback, which was announced at the same time as the ailing newspaper group unveiled figures showing the flagship Daily Mirror’s advertising revenue had fallen 13.5% year-on-year along with a drop in circulation.

On the face of it, Next, the well-known clothing retailer, has done shareholders proud. But broker Collins Stewart called it ‘buyback junkie par excellence’ in its recent research note saying Next is a good example of putting the interests of shareholders and management in direct opposition.

Between 2000 and 2007 the company bought back a third of its shares, creating considerable value for continuing shareholders. Between April and November 2007, Next spent a further £474 million repurchasing 10% of its shares as the price fell.

At the end of November these shares had a market value of £374 million, or £70 million less than they were worth six months earlier. But the buyback did increase EPS by some 6%, which coincidentally exceeds the 5% performance measure, after which point a big annual performance bonus is paid to the directors.

‘The directors are in the money even if operating performance is flat,’ says Collins Stewart pointing out that the top four executives collected an extra £360,000 between them in 2007 as a result of the buybacks.

Other companies using buybacks as a diversionary tactic include Imperial Tobacco and Boots. Imperial Tobacco stepped up its repurchasing programme in 2006/07 just after a group of European countries banned smoking in public places and the UK announced it would introduce a smoking ban.

Boots seemed to have run out of options except to increase share buybacks, after its management failed to lift profits, bodged the company restructuring and made several unsuccessful diversifications into dentistry and beauty treatments.

Managerial opportunism

Warren Buffet says managements often attempt to ramp up the share price and other key ratios to boost their remuneration. Chief executive salaries at FTSE 100 firms soared by 58% on average between 2003 and 2007 but total remuneration rocketed by 208% according to corporate watchdog Manifest.

Big banks such as Barclays and Royal Bank of Scotland have been keen proponents of share buybacks along with big dividend payments. Controversially RBS re-jigged EPS growth targets and comparison with ten competitors, making it easier for them to be achieved, especially as it spent £1 billion buying back its shares last year.

Research just released reveals a very strong link between share buybacks and executive pay.

Dr Young says some boards of directors show an unhealthy appetite for boosting their salaries by repurchasing shares in their companies. ‘All else being equal, firms where executive bonus payments and option exercise are contingent on EPS performance are twice as likely to repurchase shares,’ says Young.

In plain English that means directors are using your cash to buy back shares and cancel them. This in turn boosts EPS to a level that triggers hefty bonus payments.

Managerial opportunism can thus be added to the growing criticism of share buybacks. There is now plenty of evidence that share prices of companies that have conducted repurchases fare worse than both the market as a whole and much worse than those firms boosting their dividends instead.

Dr Young and Jing Yang of management consultants Towers Perrin have just released their research* on buybacks and director pay. They examine whether managers’ stock repurchase decisions are ‘sensitive to explicit EPS-related incentives provided by executive compensation contracts.’

Compensation contracts linking rewards to EPS performance provide executives with direct and potentially powerful incentives to manage reported EPS. The authors therefore test whether buybacks are higher for firms that tie executive compensation to EPS performance.

Non-financial companies filing accounts with year ends from 1998-2003 were examined throwing up 384 repurchases for 217 firms.

The findings reveal a ‘significant association between stock repurchase activity and the presence of EPS-based compensation arrangements. The predicted odds of a repurchase for firms where executive compensation depends on EPS performance are almost twice the level observed for firms where rewards are independent of EPS,’ says the report.

Indeed, a company where directors are ‘incentivised’ by EPS linked pay packages has higher odds of launching a buyback programme than if the company simply had excess cashflow or scarce investment opportunities. Furthermore the higher the EPS target to trigger payouts the more likely the company is to repurchase its shares.

A previous report by Bens and colleagues in 2002 showed that managers may divert resources away from potentially value-increasing investments and toward repurchases of their own stock.

This suggests that the Holy Grail of providing incentives for managers to pursue corporate strategies that promote shareholder value is as remote as ever.

While best practice compensation guidelines do not favour any single performance metric the vast majority of firms offering performance-related pay and bonuses link them in terms of EPS growth.

* Stock Repurchases and Executive Compensation Contract Design: The role of earnings per share-based performance conditions by Steven Young and Jing Yang

BP STRIKES OUT

Oil giant BP is switching away from buybacks to dividends. After almost a decade of re-purchasing its own shares BP’s share price has hardly moved, barring a spike to the all-time high of 712p in 2006.

This is despite the mother of all paybacks. Between 2001 and 2007 BP paid shareholders $91 billion, with half from share buybacks and the rest from dividends. The number of shares has been cut by 16% since 2000.

The vast bulk of the $46 billion spent on buybacks occurred in the past four years. The share price peaked at 557p in 2004 – some 10% above the current price.

Two months ago BP signalled a new approach. It raised the dividend by a mighty 31% to shift the balance from buybacks to dividends as a ‘means of returning cash to shareholders.’

BP spokesperson Wendy Silcock said: ‘After reducing the number of shares in issue it has become less expensive to increase the dividend by a larger amount on the remainder.’

The oil giant insisted it will continue its buybacks but at a much lower rate than over the past eight years. BP pointed out it has more cash than ever before due to sky-high oil prices and faster business growth.

The group denied that tax considerations and institutional pressure had biased it toward buybacks.

LUMINAR PAYS DEARLY IN BUYBACK BENDER

Ailing nightclub owner Luminar Group Holdings’ share price chart looks like the Niagara Falls. The shares peaked at 908p in mid-2007 but are now changing hands at just 371p. Luminar has spent £76 million so far buying back millions of shares and might end up spending twice as much, as it says it is only half way through a three-year buyback programme ending next year.

Happily for smaller shareholders Luminar has not neglected the dividend. It rose 10% in 2006 and 3% last year to 17.2p despite profits falling sharply.

But the fact remains that many of the shares bought back cost over 800p and hardly any purchases seem to have taken place this year, when the price has been as low as 310p.

‘The main reason for the buyback was to focus the group after the substantial asset sales,’ said finance director Nick Beighton. ‘The group has shrunk in size so we wanted to align the number of shares in issue.’

Luminar now has some 120 clubs compared with over 300 three years ago.

Besides correcting the capital base, Luminar felt its borrowing was not at an optimal level. When bankers were throwing cash at companies it was better value to replace equity with debt. Even so Luminar is only geared up 43%, which should not worry credit crunch watchers too much.

The company consulted its big shareholders, such as Schroders with 19% and Hermes with almost 15%, before unveiling its buyback scheme. It also talked to analysts.

‘The buyback plan was well received when we announced it in May 2006,’ said Beighton.

Initially the shares rose sharply from 500p to 800p at the end of 2006. Indeed all was well until last autumn when most leisure company shares dropped sharply.

‘The Luminar price fell in line with other share prices in the sector,’ said Beighton.

He has no regrets about the buyback saying it has done its job.